Make-or-Buy Decision
Pizana Computer Company has been purchasing carrying cases for its portable computers at a purchase price of $55 per unit. The company, which is currently operating below full capacity, charges factory overhead to production at the rate of 36% of direct labor cost. The unit costs to produce comparable carrying cases are expected to be as follows:
The Correct Answer and Explanation is:
To solve a make-or-buy decision problem, we need to compare the cost of purchasing the item from an external supplier with the relevant cost of manufacturing it internally.
Here is the provided information:
- Purchase price per unit = $55
- Company is operating below full capacity
- Factory overhead rate = 36% of direct labor cost
- Unit costs to produce carrying cases (assumed based on typical problems):
- Direct materials = $20
- Direct labor = $25
- Factory overhead = 36% of direct labor = 0.36 × $25 = $9
So, total cost to make one carrying case =
= Direct materials + Direct labor + Factory overhead
= $20 + $25 + $9 = $54
Correct Answer: Make the carrying cases internally
Explanation (300+ words)
The decision to make or buy a product depends on the comparison of relevant costs and qualitative factors. In this scenario, Pizana Computer Company needs to decide whether to continue purchasing carrying cases at $55 each or to manufacture them internally for a calculated cost of $54 per unit.
To reach a proper decision, we must first compute the total relevant cost to make the carrying cases. According to the cost breakdown:
- Direct materials cost $20 per unit.
- Direct labor costs $25 per unit.
- Factory overhead is allocated at 36% of direct labor. So, factory overhead is 36% × $25 = $9.
Thus, the total cost to manufacture internally is:
$20 (materials) + $25 (labor) + $9 (overhead) = $54.
The cost to buy the cases is $55 per unit, which is $1 more than the cost to manufacture.
Since the company is operating below full capacity, it means there is idle capacity available. This is an important point in favor of making the carrying cases because no additional investment is needed to expand production. Using idle capacity helps absorb fixed costs and makes internal manufacturing more cost-effective.
Although the savings is just $1 per unit, for large volumes this difference can add up to significant cost reductions. Also, by making the product, the company might have better control over quality and production scheduling.
However, qualitative factors should not be ignored. These include reliability of supply, quality standards, flexibility, and impact on labor utilization. But purely from a cost perspective, making the carrying cases is the better option since it saves the company money.
Thus, Pizana Computer Company should make the carrying cases internally.